Multi Currency Credit Default Swaps: Quanto Effects and FX Devaluation Jumps

Abstract

Credit Default Swaps (CDS) on a reference entity may be traded in multiple currencies, in that protection upon default may be offered either in the currency where the entity resides, or in a more liquid and global foreign currency. In this situation currency fluctuations clearly introduce a source of risk on CDS spreads. For emerging markets, but in some cases even in well developed markets, the risk of dramatic Foreign Exchange (FX) rate devaluation in conjunction with default events is relevant. We address this issue by proposing and implementing a model that considers the risk of foreign currency devaluation that is synchronous with default of the reference entity. As a fundamental case we consider the sovereign CDSs on Italy, quoted both in EUR and USD. We explain in detail the sources for such discrepancies. Our modeling approach is based on the reduced form framework for credit risk, where the default time is modeled in a Cox process setting with explicit diffusion dynamics for default intensity/hazard rate and exponential jump to default. For the FX part, we include an explicit default-driven jump in the FX dynamics. As * Imperial College, London, U.K. our results show, such a mechanism provides a further and more effective way to model credit / FX dependency than the instantaneous correlation that can be imposed among the driving Brownian motions of default intensity and FX rates, as it is not possible to explain the observed basis spreads during the Euro-debt crisis by using the latter mechanism alone.

Sovereign credit risk and exchange rates: Evidence from CDS quanto spreads

“…The model is more parsimonious than the most general one (loadings δ * s control both expectations and innovations). This expression also shows that we can explore the question of whether regular innovations or jumps in the depreciation rate contribute the most to the magnitude of quanto spreads (see Brigo, Pede, and Petrelli, 2016;Carr and Wu, 2007;Ehlers and Schoenbucher, 2004;Krugman, 1979;Lando and Nielsen, 2017; Monfort, Pegoraro, Renne, and Roussellet, 2017; Na, Schmitt-Grohé, Uribe, and Yue, 2017 for related discussions).…”

“…DeSantis (2015) uses quanto spreads to construct measures of redenomination risk. No-arbitrage term structure models for quanto spreads are proposed by Ehlers and Schoenbucher (2004) for Japanese corporate CDS, and by Brigo, Pede, and Petrelli (2016) for Italian CDS.…”

Examples of Wrong-Way Risk in CVA Induced by Devaluations on Default

“…(57)). For the expOU model calibration, we refer in particular to [1] where calibration is discussed extensively and where 3 year daily calibration outputs relying on quanto CDS spreads are presented.…”

“…The calibration and approximation techniques showed in this paper can be used, for example, to connect currency devaluation with multi-currency Credit Default Swap (CDS) par-spreads (see [1] for more details) and that, in turn, allows to calculate CVA more accurately. The resulting FX/credit cross modeling improvement is crucial where the interaction between the counterparty credit and the FX is strong, i.e.…”

Sovereign CDS Calibration Under a Hybrid Sovereign Risk Model

“…Our approach is similar to [2] where the authors presented a model that captures the link between the sovereign default intensity and the foreign exchange rate by adding a constant in case of credit event to this exchange rate process. As shown in [5], the introduction of a jump in the dynamic of FX rate is necessary since a purely diffusion-based correlation between the exchange rate the hazard rate is not able to explain market observations.…”